Cash conversion cycle

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In management accounting, the Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. [1] It is thus a measure of the liquidity risk entailed by growth. [2] However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and tax payments is not always sustainable.

Management accounting field of business administration, part of the internal accounting system of a company

In management accounting or managerial accounting, managers use the provisions of accounting information in order to better inform themselves before they decide matters within their organizations, which aids their management and performance of control functions.

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Contents

Definition [3]

CCC=# days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.
 
=Inventory conversion period  +  Receivables conversion period  Payables conversion

period

 
=Avg. Inventory
COGS / 365
  +  Avg. Accounts receivable
Sales / 365
  Avg. Accounts payable
Purchases / 365

Derivation

Cashflows insufficient. The term "Cash Conversion Cycle" refers to the timespan between a firm's disbursing and collecting cash. However, the CCC cannot be directly observed in cashflows, because these are also influenced by investment and financing activities; it must be derived from Statement of Financial Position data associated with the firm's operations.

Equation describes retailer. Although the term "cash conversion cycle" technically applies to a firm in any industry, the equation is generically formulated to apply specifically to a retailer. Since a retailer's operations consist of buying and selling inventory, the equation models the time between

(1) disbursing cash to satisfy the accounts payable created by purchase of inventory, and
(2) collecting cash to satisfy the accounts receivable generated by that sale.

Equation describes a firm that buys and sells on account. Also, the equation is written to accommodate a firm that buys and sells on account. For a cash-only firm, the equation would only need data from sales operations (e.g. changes in inventory), because disbursing cash would be directly measurable as purchase of inventory, and collecting cash would be directly measurable as sale of inventory. However, no such 1:1 correspondence exists for a firm that buys and sells on account: Increases and decreases in inventory do not occasion cashflows but accounting vehicles (payables and receivables, respectively); increases and decreases in cash will remove these accounting vehicles (receivables and payables, respectively) from the books. Thus, the CCC must be calculated by tracing a change in cash through its effect upon receivables, inventory, payables, and finally back to cash—thus, the term cash conversion cycle, and the observation that these four accounts "articulate" with one another.

LabelTransactionAccounting (use different accounting vehicles if the transactions occur in a different order)
A

Suppliers (agree to) deliver inventory

→Firm owes $X cash (debt) to suppliers
  • Operations (increasing inventory by $X)
→Create accounting vehicle (increasing accounts payable by $X)
B

Customers (agree to) acquire that inventory

→Firm is owed $Y cash (credit) from customers
  • Operations (increasing sales/revenue by $Y)
→Create accounting vehicle (increasing accounts receivable of $Y)
C

Firm disburses $X cash to suppliers

→Firm removes its debts to its suppliers
  • Cashflows (decreasing cash by $X)
→Remove accounting vehicle (decreasing accounts payable by $X)
D

Firm collects $Y cash from customers

→Firm removes its credit from its customers.
  • Cashflows (increasing cash by $Y)
→Remove accounting vehicle (decreasing accounts receivable by $Y.)

Taking these four transactions in pairs, analysts draw attention to five important intervals, referred to as conversion cycles (or conversion periods):

Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period.)

Hence,

interval {C → D}=interval {A → B}+interval {B → D}interval {A → C}
CCC (in days)=Inventory conversion period+Receivables conversion periodPayables conversion period

In calculating each of these three constituent conversion cycles, the equation Time = Level/Rate is used (since each interval roughly equals the Time needed for its Level to be achieved at its corresponding Rate).

Cost of goods sold carrying value of goods sold during a particular period

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

Revenue income that a business has from its normal business activities

In accounting, revenue is the income that a business has from its normal business activities, usually from the sale of goods and services to customers. Revenue is also referred to as sales or turnover. Some companies receive revenue from interest, royalties, or other fees. Revenue may refer to business income in general, or it may refer to the amount, in a monetary unit, earned during a period of time, as in "Last year, Company X had revenue of $42 million". Profits or net income generally imply total revenue minus total expenses in a given period. In accounting, in the balance statement it is a subsection of the Equity section and revenue increases equity, it is often referred to as the "top line" due to its position on the income statement at the very top. This is to be contrasted with the "bottom line" which denotes net income.

Aims

The aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. The standard of payment of credit purchase or getting cash from debtors can be changed on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, past credit policies can be maintained. Its aim is also to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis. [4] The CCC readings can be compared among different companies in the same industry segment to evaluate the quality of cash management. [5]

Cash flow statement financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities

In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7, is the International Accounting Standard that deals with cash flow statements.

See also

Days in inventory is an efficiency ratio that measures the average number of days the company holds its inventory before selling it. The ratio measures the number of days funds are tied up in inventory. Inventory levels are divided by sales per day

Days payable outstanding (DPO) is an efficiency ratio that measures the average number of days a company takes to pay its suppliers.

In accountancy, days sales outstanding is a calculation used by a company to estimate the size of their outstanding accounts receivable. It measures this size not in units of currency, but in average sales days.

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References